[NOTE: I orginally meant for my blog to be a collection of my thoughts about a variety of topics, but due to some personal and professional events, I’ve basically only found time produce a crappy Sports Guy knock-off. Sorry about that. Anyway, here is my first non-sports post.]
We’ve heard it all. $700B bailout of Wall Street blamed on everything from foreigners to home builders to those fat cats on Wall Street. I don’t have the answer. And we won’t get to one, at least a long lasting solution, until we figure out exactly who to blame. As unsexy as it sounds, the major problem here is improper risk evaluation.
To explain the problem, let’s look a really simple example. Two people want a $500K mortgage to buy a two identical houses right next to each other. Person A has excellent credit and a pretax salary of $200K per year. Person B makes $50K per year and has bad credit. If both mortgages were packaged individually as an investment, which one would you buy?
If the expected return on each investment was the same, you’d buy Person A’s mortgage. He has good credit and an income level that supports his ability to repay the mortgage. On paper, the risk of default by Person B is really high, so you would need a much higher return to justify the risk.
In a nutshell, that’s the problem we see today. Banks buddled a bunch of mortgages with a high default probabilities together and ignored the risk of default. When the housing market cooled and people who clearly were not going to be able to repay the mortgages defaulted, banks were left with mortgage-backed securities that were not worth much. So they need money to meet their legal capital requirements, but all the other banks are in the same boat, so they aren’t going to buy the bad securities or loan money to banks that are loaded up with them. That’s what the $700B is supposed buy; crappy securities that nobody else wants.
We’ve seen other examples of this. Enron is a great example. That company was a black box and many people just took the company at its word that things were going great. One day the house of cards came tumbling down.
I am certainly no financial expert nor am I an accountant. But I can promise that if we do not solve the ability of banks and companies to value their dirt as gold, we’ll be right back here again in another decade. And the solution is not to eliminate the dirt. If people or institutions could not loan money to long shots, like small businesses, we may stiffle innovations and new jobs. Risk is like a sharp knife. If used properly by somebody who knows what they are doing, it can be an excellent tool. If it’s just thrown around, you can kill yourself.
